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Revenue growth can't mask razor thin profits

June 2016

Recent developments in the shaving industry reveal much about the distortive effects of low interest rates, argues Giles Parkinson.

Where did you buy your last razor? If it was posted to you as part of a subscription then you are part of the biggest change to hit the shaving industry since disposable razors were introduced in the 1970s.

The trend to subscription-based razors is most developed in America. Almost a third (31 per cent1) of razor blades sold in the US in 2015 were supplied by online ‘shave clubs’. The concept is simple: for a monthly subscription costing a few dollars, a company such as market leader Dollar Shave Club sends customers a box of disposable heads. Club members face no fees, no commitment and can cancel their subscription at any time.

On a per unit basis, the blades are roughly half the price of equivalent products bought in a shop. However, the subscription means that users end up changing their blade four times as often, so that overall they spend twice as much1.

Gillette, the dominant incumbent, used to be a highly profitable business. After all, it is the original “razor/razor blade” business model. The world’s richest investor, Warren Buffett, once called it an “Inevitable” and owned nine per cent of the company when it was acquired by Procter & Gamble in 2005.

Since then, sales volumes and profit margins in Procter & Gamble’s grooming business have been under pressure, with the market share of the Gillette brand in the US falling since mid-2013. And, the rise of online shave clubs since 2012 seems to be the culprit.

Show me the profit

While the online shaving clubs have succeeded in rapidly gaining market share, profitability is proving altogether more elusive. Despite making $153 million2 in revenue last year and receiving $160 million3 in funding from investors, Dollar Shave is still loss-making. Gillette’s sales and profits have slipped; but while the sales are going to the shave clubs, the profits are not. An economist would say it is into a ‘consumer surplus’ – the difference between what a consumer is willing to pay for a good or service, and what they are actually charged.

In effect, the online shave clubs are under-pricing the cost of their deliveries. This generates fast revenue growth as consumers flock to buy something they perceive offers good value. Dollar Shave’s revenues soared by 135 per cent in 2015 and are expected to grow by 57 per cent this year. The strong growth has caught the attention of investors, who seem content to continue funding the business indefinitely. Yet no-one seems to ask the question: would Dollar Shave grow this quickly, and be worth so much, if it needed to make a profit? Meanwhile, Procter & Gamble remains under remorseless competitive attack.

This phenomenon is not unique to shaving. The American Craft Spirits Association estimates there are over 800 distilleries operating in America, opening at a rate of six per week, but only 50 are profitable4. It is not difficult to find new, challenger companies threatening a range of industries with years of operation, millions in revenue, and multi-billion valuations, but yet to make meaningful profits and free cash flow. Ocado (grocery retail); AirBnB (hotels); Uber (licenced taxis and car rental); Netflix (cinemas and television); and Tesla (conventional cars) all represent a massive threat to incumbents.

It wasn’t always this way. Yesteryear’s start-ups such as Google, eBay and Rightmove only required a few million dollars of outside funding to develop a popular product, grow quickly and make wide margins. Today, the idea is to build a winner-takes-all ‘platform’ with self-reinforcing ‘network effects’ to boost use and ‘jam-tomorrow’ profitability.

One plausible explanation why the challenger companies have not yet been subject to severe investor scrutiny is the persistently low interest rate environment.

If the value of any asset is the present value of future earnings, in a near zero-rate world cash next year will be worth almost the same as it is now. While the cost of money remains so cheap, the incentive to make a profit today is not as acute. For these companies, it seems the mantra is to under-price the product, spend revenues on customer service and marketing, and maximise growth.

Commentators frequently debate how much harm interest rate hikes will have on asset valuations. But this overlooks the distortive impact that low interest rates can have on profitability. Consumers are winning for now in a whole host of markets, but investors need to be far more discerning when assessing the long-term viability of the new kids on the block, as well as the traditional powerhouses whose business models are under threat.

1 Source: What Shave Clubs Don't Want You to Know and Why Schick Needs to Play Ball, Jeffries, 11 November 2015

2 Source: A changing environment for online shaving clubs in the US, Euromonitor, 21 February 2016

3 Source: Dollar shave clubs butt wipes will help lead it to profit this year, Fortune, 16 May 2016

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In Summary

In the biggest trend to hit male grooming since the 1970s, almost a third of razor blades sold in the US in 2015 were subscription-based sales

When the cost of borrowing is so cheap, the incentive to make a profit today dissipates

It is not difficult to find companies threatening industries with years of operation, millions in revenue and multi-billion valuations but yet to make meaningful profits and free cash flow

Commentators frequently debate how much harm interest rate hikes will have on asset valuations. But this overlooks the corrosive impact that low interest rates are having on incumbents’ profitability

Giles Parkinson

Fund Manager, Global Equities

Main responsibilities

Giles is responsible for the management of our Global Equity Endurance Fund. Prior to joining Aviva Investors, Giles held positions as an analyst at Artemis Investment Management and before that at Newton Investment Management.

Experience and qualifications

Giles holds a BA in History from Durham University and an MPhil in Historical Studies from Cambridge University. He is also a CFA® charterholder.